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Berk and Green (2004) have made a strong theoretical argument for why past performance should not predict future performance. There are two possible economic explanations that are consistent with their model: increasing expenses or increase in size following good performance along with diseconomies of scale.

We show that expense ratios and management fees decline with size and decline with success, with the top-performing funds decreasing fees and the poor-performing funds increasing fees. The other possible way that predictability might disappear is for funds to grow with good performance and for diseconomies of scale to erode performance. If this is true, then we should see no predictability when funds get larger.

We examine this in a number of ways. We find that size is not significantly related to future alpha. The relationship of future alphas and past alphas does tend to weaken over longer periods, but even for a 3-year period, the future alpha has a relationship to past alpha which is statistically significant. A one-standard-deviation increase in past alpha implies an increase in the average yearly alpha over the following 3 years of 23 basis points per year.